Soaring with the Hawks - Macro Horizons

Ian Lyngen:

This is Macro Horizons, episode 305: “Soaring with the Hawks” presented by BMO Capital Markets. I'm your host, Ian Lyngen here with Ben Jeffery to bring you our thoughts from the trading desk for the upcoming week of December 23rd. And with the Fed's final decision of 2024 out of the way, we are now shopping for last minute gifts, making New Year's Eve plans and revisiting our 2024 resolutions, only to conclude that maybe next year will be our year.

Each week we offer an updated view on the US rates market and a bad joke or two, but more importantly, the show is centered on responding directly to questions submitted by listeners and clients. We also end each show with our musings on the week ahead. Please feel free to reach out on Bloomberg or email me at ian.lyngen@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible. So that being said, let's get started.

In the week just passed, we saw a decidedly hawkish Fed cut rates by 25 basis points, but signal that in 2025, the Fed has penciled in only two more quarter point cuts, which would leave effective Fed funds at 3.9% by the end of 2025. They also increased the 2026 dot to 3.4% from 2.9 and edged higher 2027 to 3.1% and even the longer run dot was revised slightly higher to 3%. It's important to keep in mind that as the debate about whether or not neutral is higher post-pandemic continues, the Fed's messaging has been pretty consistent that neutral is a difficult rate to estimate. However, over the course of the last year, the longer run dot has been increased from 2.5% in the December 2023 SEP, all the way up to 3% in December 2024. All this suggests that the Fed has at least indirectly acknowledged an increase in neutral.

Putting this in the context of forward monetary policy expectations, it's not that surprising to see that given the election outcome, the trajectory of rate cuts in 2025 and 2026 will be slowed. What was surprising, to us at least was that the Fed chose to signal two, instead of three, rate cuts next year.

We continue to see January as the most logical meeting for the Fed to skip. It occurs shortly after Trump retakes the White House and by skipping January, the Fed will have an opportunity to evaluate some of the initial actions coming from Trump in terms of a trade war or tariffs, et cetera, and more effectively incorporate them into the March SEP. The decision whether or not to cut in March will more than likely be a function of the economic data as opposed to anything on Trump's agenda. With that backdrop, it's notable that within the Fed's SEP, they also increased the core inflation outlook for 2025 to 2.5% from what had been a relatively benign 2.2%.

What the Fed has effectively done is they've given themselves another calendar year to get inflation back to the actual 2.0 target. The Fed doesn't have core inflation returning to 2% until 2027. Interestingly, the Fed chose to lower the 2025 employment projection to just 4.3%. For context, in November the unemployment rate was a very high 4.2, which could have readily rounded it up to 4.3. So for all intents and purposes, the Fed has messaged to the market that as long as the unemployment rate doesn't increase any further from here, then two 25 basis point rate cuts will be the most likely outcome in 2025.

We struggled to envision a scenario in which the unemployment rate doesn't increase in 2025 at least slightly, and it's not difficult to envision a 4.5 or a 4.6 unemployment rate and concerns shifting back to the employment mandate. For the time being however, one of the biggest takeaways from the Fed is that inflation is once again front and center in setting the Fed's monetary policy agenda.

Ben Jeffery:

While it was the last real event of the year, no disrespect to next week's Treasury auctions, but the FOMC followed through with its 25 basis point cut, which brings the aggregate amount of easing delivered since September to a full percentage point. The big surprise at the December Fed came in the form of the forward guidance offered via both the SEP and Powell's press conference, the former showing a median projection of just 50 basis points in easing projected next year with some reasonable increases to core inflation estimates at the end of 2025 and 2026 as well, which in the aftermath of the meeting prompted several questions from clients, which was, "If in fact monetary policy is still restrictive, then why is the committee revising up its core inflation forecast? And more importantly, if the committee is revising up its core inflation forecast, why does the Fed need to continue cutting at all?"

And to look at two year yields effectively in line with overnight rates and 10 year yields back above 4.50%, the market is clearly beginning to question the degree to which any further rate cuts are going to be justified in 2025 or even beyond.

Ian Lyngen:

And that's the big question. The big question really is whether the Fed is signaling that they're incorporating enough of a potential trade war and the fallout on the inflation front into the forward projections already, or if we're going to have another round of upward revisions to inflation estimates and the dot plot, come the March SEP. And obviously, there's a lot of economic data between now and the 19th of March, but at the end of the day, the present trajectory suggests the real economy remains on solid footing and while the unemployment rate is well off of this cycle's low, the Fed has been consistent in its welcoming of a cooler but not cold labor market.

It was notable during the press conference that when asked about how the incoming administration has influenced the SEP and the dot plot, Powell candidly noted that some members incorporated this factor into their estimates, some members did not, and some members did not disclose whether or not they did. All of this suggests that to one degree or another, the Fed is already getting in front of what could be a reflationary impulse once Trump retakes the White House.

Ben Jeffery:

And we've discussed how tariffs are more a one-off increase in prices as opposed to a true game-changer in changing the trajectory of longer term inflation. But there's also the flip side of this argument to consider as it relates to what tariffs will mean for growth and the ability of households to bear the burden of higher prices that are going to have to be increasingly passed on to end users.

It's a tax on consumption argument and one that, despite the positive adjustments to the near-term growth outlook, both within the SEP, but also what we've seen in several sentiment measures recently, it certainly doesn't ensure that we're on the precipice of a recession, but it is an important negative growth variable to consider given the fact that thus far with this week's retail sales data, the most recent example, consumption remains undoubtedly solid and that's been a derivative of solid wage gains that have accompanied the firmer jobs reports we've gotten recently, which all has left the no landing narrative intact.

But to listen to some of Powell's underlying concerns about the longer term trajectory of the labor market at the press conference on Wednesday, there's clearly some worry that there's more pain yet to be realized in the labor market and given the distortions that have been imparted on Q4’s data, the challenge in interpreting the latest jobs data has left the Fed to err on the side of staying committed to continue normalization until there's more data in hand and we have a clearer sense of if the labor market is actually recovering or if the latest period of strength is just a transitory period of firmness on what is still the longer-term trend upward in the unemployment rate.

Ian Lyngen:

And the evolution of the real economy has afforded the Fed the ability to continue to let the balance sheet run off in the background. The messaging from the Fed at the December meeting showed no inclination to begin the process of winding down QT anytime soon. And if anything, by signaling only two rate cuts in 2025, the Fed is indirectly hinting that they might attempt to let the balance sheet run down throughout all of calendar 2025.

Now, in the absence of any significant funding stress around the year in turn, it's likely that the Fed will have continued confidence in the programs that it has put in place since the September 2019 moment of reserve scarcity. The Fed also announced its decision to lower the rate on the overnight reverse repo program, or RRP, by an extra five basis points for an aggregate of a 30 basis point cut. We'll argue that this was in part an olive branch to some of the doves on the committee who might be particularly concerned about the funding market into the end of the year.

There is currently only $130 billion in utilization of the RRP program, and expectations are for this to decline even further in the wake of the most recent Fed change.

Ben Jeffery:

And in talking with money market participants first after the minutes laid the groundwork for this change to be made and then subsequently as the Fed was preparing to follow through on that messaging, there's not a great deal of conviction that the tweak in the RRP is really going to change much of anything from a funding market perspective. And to your point, Ian, really its value was more as a signaling tool that the Fed is paying attention to what's going on in the funding market. And while that has not been enough to alter the messaging as it relates to QT, we've reached the point in the cycle when there's been enough liquidity drained from the system that the FOMC is comfortable starting to disincentivize use of the RRP, which in practical terms is simply a diversification tool for money market funds that are now able to get a risk-free overnight return at the Fed.

Now this begs the question, what does a five basis point adjustment do in moving some of that just over a hundred billion in money in the RRP into other parts of the market? Repo comes to mind, the bill market does as well, but given how far reverse repo balances have fallen, we've reached the point of stickiness that means further declines from here are likely going to be increasingly difficult to realize.

As the tweak flows through to the broader market as well, it also remains to be seen what dropping the RRP rate to the bottom of the target band means for where Fed effective sets within the target zone. And while we're not of the opinion it's worth more than a basis point or two, it's worth considering just how comfortable the Fed would be with EFFR not eight basis points above the bottom of the band, but something a little bit tighter. Obviously not something that's going to dictate the path of ten-year yields, but particularly as we watch the money market space heading into the end of the year, something to consider now that the Fed decision is behind us.

Ian Lyngen:

On the topic of influencing the direction of ten-year yields, we are at an interesting point in the cycle where the market has once again pushed ten-year yields above 4.50%, and it's difficult to envision a bullish run between now and the end of the year that gets ten-year yields closer to 4%. Getting us to the 200-day moving average of 4.20% seems like a much more doable target, but we would need to see more dip buying interest emerge and in light of the uncertainty introduced by the Fed events, we're content with the notion that the longer end of the curve is going to continue a process of consolidation with a modest downward drift in yields. The more interesting price action is already occurring in the very front end of the market.

During the overnight session that immediately followed the FOMC's decision, volumes were twice their typical levels and the front end of the market outperformed. Not only did it outperform relative to the longer end of the curve which did sell off, but two-year yields actually declined on an outright basis. This suggests that the effective Fed funds rate at 4.33% is going to function as an anchor, if not a ceiling for nominal two-year yields, at least over the course of the next two or three weeks until we have greater clarity on the performance of the real economy during the final quarter of the year.

Ben Jeffery:

And in talking about two-year yields that are now effectively matching effective Fed funds, no pun intended, what we've learned over cycles past is that the market is always going to be extremely reluctant to price a flat path of policy any further than the next quarter, maybe two. And so as we think about the appropriate level of two-year yields, what that means mechanically is that so long as the Fed still has an easing bias and hikes are not actively being considered, as we heard from Powell at the press conference, what that means is that effective Fed funds should be the highest two-year yields ever reached. In the event we see a selloff beyond that 4.33%, 4.35% level, that's the market saying that there's some probability over a rate hike over the next two years.

And while not an impossibility based off the Fed's communication and based off the longer term trend of the data we've seen since inflation really started cooling last year and we've started to see the unemployment rate move higher, it seems unlikely that the Fed is actively going to entertain the idea of re-tightening and then the most hawkish outcome instead would be content to stay on hold signaling that the next move is a cut, but it's just been delayed another meeting or two. And as long as that messaging stays intact, that rates are in a good spot, but the next move is a cut, that should keep two-year yields below effective Fed funds.

Ian Lyngen:

So what you're effectively saying, Ben, is that in the event that the Fed holds monetary policy stable for the next year, doing nothing is still hard work.

Ben Jeffery:

And I know a lot about that.

Ian Lyngen:

In the week ahead, the Treasury market has a midweek holiday on Wednesday for Christmas day and an early close on Tuesday, the recommended early close being 2 PM. The nuances of the holiday schedule will likely create enough of an incentive for many in the market to simply take the next two weeks off, ourselves included.

What will be interesting will be to see the net price action over the next two weeks. The end of the year in the Treasury market is notorious for choppy price action that ultimately doesn't end up being sustainable once the market returns in full force during the first full week of January. The Fed left the market with a decidedly hawkish tone from a monetary policy perspective, and that's going to make it difficult for the Treasury market to stage a year-end rally of any magnitude.

We're anticipating that the market continues to consolidate in its current range, and if there's any bullishness to be expressed, it most likely will come in the two-year sector.

The week ahead also includes a $69 billion 2-year auction on Monday, followed by a $70 billion 5-year auction on Christmas Eve. The 7-year at $44 billion is on the 26th of December, and will mark the final installment of coupon auctions for 2025.

As we consider the first week of January, the most obvious piece of new information that will set the tone for trading early in the new year comes in the form of the December jobs report. Expectations will be for a relatively benign gain in headline payrolls, but more importantly, investors will see whether or not the upward trajectory of the unemployment rate continues. In the event of an upside surprise of a 4.3% or a 4.4%, that would present a material challenge to the Fed's prevailing narrative that the jobs market is cooling, but not cold.

We're on board with that interpretation for the time being, but as we look forward to 2025, one of the most obvious risks comes in the form of a spike in the unemployment rate. Now, we find ourselves reluctantly leaning toward the no landing camp, not necessarily because of the impressive performance of the real economy, but when that's combined with the fact that the Fed has already lowered policy rates by a hundred basis points and is signaling another 50 basis points in 2025, Powell has, for all intents and purposes, doubled down on the Goldilocks economy and despite the recent hawkishness and refocus on the trajectory of inflation, remains committed to the employment component of the dual mandate.

Translating that into a market bias, we do see the current level of 10- and 30- year yields as a buying opportunity, but ultimately expect that the sharpest price action will come in the front end of the curve as we see the potential for two year yields to return below 4% more quickly than 10s and 30s. This is consistent with our curve steepening bias, and we expect that that will be the one discernible trend over the course of the next two or three weeks.

We've reached the point in this week's episode where we'd like to offer our sincere thanks and condolences to anyone who has managed to make it this far. And as this will be our final episode of 2024, we'd like to wish everyone a great holiday and a happy New Year. And remember, if you're running short of ideas, nothing spreads holiday cheer like subscribing to Macro Horizons. The price is right, even more so on an inflation adjusted basis.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode, so please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show has been produced and edited by Puddle Creative.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.